Friday, September 18, 2009

Price ceilings in power exchanges

In a landmark decision, the Central Electricity Regulatory Commission (CERC) has finally imposed a price band on electricity sales in power exchanges and bilateral markets, in an effort to curb the runaway price increases and volatility in a massively deficient electricity market (peak shortage estimate of 18.1% for 2009-10). The price band from 10 paise per unit to Rs 8 per unit would cover all inter-state day ahead trades for a period of 45 days.

Generators and traders had opposed any price ceilings on the grounds that it would deprive the market of generation capcity. However, by fixing the price ceiling by taking into account the prevailing market price of the high cost liquid fuels, the CERC has ensured that there is no economic incentive for generators to keep their plants idle.

The CERC points to the increase in prices of electricity traded in the Indian Energy Exchange (IEX) between 6 and 7 PM from Rs 5 per unit to Rs 14.5 per unit in the period from 3.08.2009 to 13.08.2009. Given the fairly stable global fuel prices, cost considerations cannot explain this steep 2.89 times rise in the 10 day period. Let us model the market by assuming Rs 5 per unit as the equilibrium market value based on the actual cost of production and Rs 14.5 as the equilibrium traded price in the exchanges.

The quantities demanded at exchange equilibrium price of Rs 14.5 is Qe, at the ceiling price of Rs 8 is Qc, and at the initial market price of Rs 5 is Qm. At a market price of Rs 8, from the generators original supply curve (based on their cost of production) it is clear that they would be willing to supply a quantity of Qc(sup). Since Qc > Qe, the quantity of electricity generated and consumed increases with the price ceiling, thereby lowering the deadweight loss.

A price ceiling that is fixed at the marginal cost of the highest cost fuel is the most efficient rationing price. At this price, all the available generators will be able to get back atleast their marginal cost of production. The CERC has accordingly placed the ceiling price at Rs 8, equivalent to the marginal cost of production of high cost liquid fuel generators. At a lower price ceiling, there will be idle generation capacity.